Why Credit Risk in Bonds May Not Be Worth It Right Now.
The chart above says it all.
Investors are often drawn to corporate bonds or high-yield bonds, which typically offer higher yields in exchange for taking on credit risk.
However, in the current market environment, this strategy no longer is as attractive as it seems. Credit spreads, the difference in yield between corporate bonds and risk-free government securities—have narrowed significantly, eroding the potential reward for taking on additional risk. The chart above shows 1.03% of additional yield on a bond that is barely above what the market calls “junk” status.
Credit spreads are meant to compensate investors for the risk of default and economic uncertainty. When these spreads are wide, corporate bonds (triple BBB rated and above) and high-yield bonds (BB rated and below) may offer a compelling risk-reward tradeoff.
However, when spreads tighten to historic lows, as they now, investors earn only a marginally higher return for taking on significantly greater risk.
This narrow-spread environment reflects a market priced for perfection, with investors seemingly confident in low default rates and stable economic conditions.
But any signs of trouble in the form of:
- Higher interest rates,
- Economic slowdown (recession), or
- Corporate downgrades
Any of these could quickly destabilize credit markets and therefore negatively impact corporate and high-yield bonds.
In such a scenario, the meager extra yield would hardly compensate for the risk of capital loss.
Instead of reaching for yield in credit markets, investors should consider higher-quality government bonds or other assets with more attractive risk-adjusted returns. With spreads this tight, the math just doesn’t add up for taking credit risk.
It’s a time to prioritize safety over greed.
-Paul R. Rossi, CFA